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Quarter-End Insights

Energy: Rally in the Works, but It Won't Last Long

We expect a medium-term oil price rally in 2018 but remain bearish on long-term oil prices.

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  • Energy sector valuations remain frothy, with a market-cap-weighted price/fair value average of 1.22.
  • Underinvestment is laying the ground for oil prices to rally, but recent U.S. rig additions could weaken the recovery's strength.
  • Relative to our previous outlook, we expect a medium-term oil price rally in 2018, driven by increased 2017 demand forecasts coupled with supply disruptions in Venezuela and Nigeria. However, we remain bearish on long-term oil prices.

Crude markets have tightened a good deal in recent months, as strong demand growth and supply issues have pulled forward industry recovery by about a year, relative to our previous outlook. Fundamentals after 2017 are looking particularly bullish for prices, and an oil price rally in 2018 is looking more likely.

Industry conditions begin to look much stronger post-2017, as a collapse in new nonshale capacity additions and growing demand could lead to meaningful supply shortages. We are increasingly bullish on oil prices rallying in the medium term, and have raised our WTI forecast to $65/bbl for 2018, which is the level we believe is required to drive a large-scale recovery in U.S. shale activity.

Even so, the strength of U.S. shale is lurking beneath the surface: Our analysis shows that the recent uptick in rigs and falling shale decline rates together are enough to stabilize U.S. crude production within six months. Remarkably, if activity isn't scaled back, U.S. production will begin growing in 2017 (albeit barely). This underscores the strength of U.S. tight oil: Should a price rally ensue, it is far too strong to not overheat and eventually snuff out any future oil price rally. We remain bearish on oil prices for the longer term, and we reiterate our midcycle oil price outlook of $55 WTI ($60 Brent).

Sharp curtailments in oil-directed drilling activity could reduce U.S. natural gas production growth in the near term, but the wealth of low-cost inventory in areas like the Marcellus and Utica ultimately points to continued growth through the end of this decade and beyond.

Based on a more optimistic outlook for low-cost production--primarily as a result of slowing declines in associated gas volumes, as well as improved productivity and resource potential from the Marcellus and Utica--we are reiterating our long-term marginal cost for U.S. natural gas of $3 per thousand cubic feet. We see more and more evidence that U.S. shale producers can survive (and in a few cases thrive) at much lower prices than we previously assumed.

We view energy sector valuations as frothy at current levels, but we do think the names below are worth further investigation from investors.

Marathon Petroleum (MPC)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $56.00
Fair Value Uncertainty: High
Consider Buying: $33.60

Marathon Petroleum's existing refining asset base is well positioned to capitalize on the ever-changing domestic crude market. The company is also investing to expand its midstream and retail businesses in an effort to diversify its earnings stream away from the more volatile refining business. In the longer term, the outlook for Marathon is bright, as the firm will benefit from the continued growth of tight oil and shale gas in the United States. At a price/fair value estimate ratio of 0.74, the current stock price offers an attractive entry point for long-term investors.

HollyFrontier (HFC)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $44.00
Fair Value Uncertainty: High
Consider Buying: $26.40

HollyFrontier operates a high-quality set of refining assets located solely in the midcontinent, Rockies, and Southwest regions. Currently, it's suffering from weak product margins, narrow crude spreads, and high renewable fuel supply costs. While we do not expect these poor conditions to persist, the market appears to be discounting a continuation for several years. Furthermore, we do not think investors are fully crediting Holly with its self-improvement initiatives. As a result, we view the shares as significantly undervalued. We expect product margins to improve with continued strong demand and a rebalancing of inventories. Meanwhile, crude spreads should widen with future U.S. production growth. At a price/fair value estimate ratio of 0.51, the current stock price offers an attractive entry point for long-term investors.

RSP Permian (RSPP)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $53.00
Fair Value Uncertainty: High
Consider Buying: $31.80

RSP Permian trades at a 30% discount to our fair value estimate of $53 per share. The firm is ideally situated in the core of the Permian Basin, and well performance across the company's position has greatly surpassed expectations in recent quarters (management notes that the average 180-day cumulative production of horizontal wells brought on line in 2016 is 20% higher than that predicted by its published type curve). As a result, we now expect the company to generate the second-highest cash margin in 2016 among shale producers in our exploration and production coverage. It's no coincidence that the one company projected to earn a higher cash margin is  Diamondback Energy (FANG), which operates adjacent acreage to RSP. However, Diamondback is trading at a higher EBITDA multiple than RSP Permian, and our discounted cash flow analysis suggests RSP Permian is the cheaper of the two stocks. This is partly because RSP has a tighter balance sheet after borrowing to fund a bolt-on acquisition in the latter part of 2015. But its leverage is only moderately higher than the peer group average, with net debt/EBITDA of 2.8 times, and it has enough liquidity to fund more than a year of drilling. The firm is expected to deleverage rapidly, and net debt/EBITDA should fall below 2 times in the first half of 2017.

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Joe Gemino does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.